Question

A piece of labor-saving equipment has just come onto the market that Mitsui Electronics, Ltd., could use to reduce costs in one of its plants in Japan. Relevant data relating to the equipment follow:

Purchase cost of the equipment	$	640,500
Annual cost savings that will be provided by the equipment	$	105,000
Life of the equipment	10 years

Required:

1a. Compute the payback period for the equipment.

1b. If the company requires a payback period of four years or less, would the equipment be purchased?

2a. Compute the simple rate of return on the equipment. Use straight-line depreciation based on the equipment’s useful life.

2b. Would the equipment be purchased if the company’s required rate of return is 13%?

Answer 1

(1)(a)-Payback period for the equipment.

Payback period for the equipment = Initial Investment Cost / Annual cash inflow

= $640,500 / $105,000 per year

= 6.10 Years

(1)(b)-Decision based Payback Period

“NO”. The Equipment would not be purchased, since the Payback Period for the Project (6.10 Years) is more than the Required Payback Period for the Project (4 Years or Less).

(2)(a)-Simple rate of return on the equipment

Annual Net Income = Annual cash inflow – Straight Line Depreciation Expense

= $105,000 – [$640,500 / 10 Years]

= $105,000 - $64,050

= $40,950 per year

Simple rate of return on the equipment = [Annual Net Income / Initial Investment Cost] x 100

= [$40,950 / $640,500] x 100

= 6.39%

(2)(b)-Decision based on Simple rate of return on the equipment

“NO”. The Equipment would not be purchased, since the Simple rate of return on the equipment (6.39%) is less than the Projects Required Rate of Return (13%).